Why Diversification Can Leave You Behind

Warren Buffett believes that "diversification is an excuse for ignorance." What he means is that when a good investment idea comes across your plate, you have to have the conviction to swing big.

If you don't have the courage to make a significant investment by putting, say, 10% of your assets into one investment, then you probably don't need to invest even 1% of your assets. Either you are confident in your analysis, or you aren't. If you can't invest big, you shouldn't invest little.

Instead of diversifying, Buffett believes in what I'd like to call a concentrated investing approach. During his early years, he was diversified, but he made his money by placing big bets on just a handful of ideas.

The lesson here is that it takes a lot of time and work to identify even 10 good investments. A carefully selected portfolio of 10 to 12 good securities can provide as much diversification as a 200-stock portfolio. Besides, even the most astute investor cannot keep track of 200 investments. And why allocate any capital to a business about which you possess only a passing degree of knowledge? Actively managing a hundred-plus-stock portfolio is mere folly, and any portfolio with that many investments should be a cause for concern.

The numbers don't lie Consider a $100 million portfolio that invested $1 million in 100 stocks. If 10 of those investments doubled, your total portfolio return would be 10%, assuming flat performance from the other investments. Although this is an oversimplified scenario, it serves to illustrate the detriment of excessive diversification.

If the same $100 million portfolio consisted of an equal investment in just 20 securities, having 10 investments double would yield a total return of 50%. To be sure, the 100-stock portfolio would lose less if several investments were to take a dive. But the point is that a 20-stock portfolio is likely to have been constructed through more diligent research and analysis than a 100-stock portfolio. By definition, then, your 20-stock portfolio should actually be less risky than a portfolio with 100 stocks. Instead of having a full basket of eggs, you put just a few eggs in your basket and watch them very closely.

All investors will suffer losses. The key to outperforming the crowd is minimizing the amount you lose and maximizing the amount you gain. You do this by carefully selecting a handful of excellent businesses at attractive prices and betting big when you find a bargain. You can even have a greater proportion of losers versus winners, because your losses will most likely be small relative to your winners. If four out of 10 investments rise 30% and the other six lose 5%, you are still doing well. A careful look at Buffett's performance in his early years reveals that his legendary record was primarily a result of big investments in companies such as American Express (NYSE: AXP) and Washington Post (NYSE: WPO) .

The records don't lie, eitherIf you think this approach no longer works today, look no further than money manager Mohnish Pabrai to understand how the right blend of concentration and diversification come together to produce top-tier investment returns.

With approximately $600 million in assets under management, Pabrai has approximately 80% of his total portfolio invested in about 10 different stocks. (As more money comes in, this concentration will be temporarily reduced until Pabrai can find the next big idea.) The bulk of his portfolio is composed of businesses that were temporarily unloved by the market but possessed superior risk/reward profiles. Such opportunities are rare, and when Pabrai finds them, he doesn't hesitate to bet big.

In the past, Pabrai and his investors have been richly rewarded with big bets on Universal Stainless & Alloy Products (Nasdaq: USAP) and Frontline (NYSE: FRO) . More recently, a big bet on Pinnacle Airlines (Nasdaq: PNCL) continues to outperform. The end result? Since 1999, Pabrai has produced an annualized return of more than 28% after all fees and expenses -- a record that places his funds in the top 1% of all actively managed funds. Had Pabrai made much smaller investments in his ideas, there is no doubt that his performance would be less than his current track record. He's engaging in what Charlie Munger wisely called "focused investing."

Indeed, it probably doesn't make much sense to have a one-stock portfolio, except maybe if the stock is Berkshire Hathaway. But it makes even less sense to have so many investments that your biggest winners become diluted by overdiversification.

Fool contributor Sham Gad is the managing partner of the Gad Partners Funds, a group of value-focused investment partnerships modeled after the 1950s Buffett Partnerships. He can be reached at sham@gadcapital.com. The Fool has a disclosure policy.

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